Global Economic Update | 01/07/2022

January 07, 2022 | Drew Pallett


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Amid all of the attention being paid to the coronavirus, there has been another development of late that may be more important for the broader markets

Drew Pallett

Happy New Year! Canada, and much of the rest of the world, is once again grappling with another wave of rising infections of Covid-19. It feels similar to the beginning of last year, although there are some stark differences that help explain why equity markets have not been negatively impacted to date. Instead, markets have been more preoccupied with a rise in bond yields to start the year, which coincidentally was also the case at the beginning of last year. We discuss these issues more below.

 

The Omicron variant, discovered just over a month ago, has rapidly become the dominant strain globally. Its high transmissibility has led to an exponential increase in global cases. While it may be much more contagious, it also appears less likely to cause severe illness. This may be a function of both the virus itself and the protection offered by vaccines. As a result, while hospitalizations are rising, the rate of change has been more modest compared to the growth in new cases. Yet, health care systems have come under strain in some areas once again given the sheer volume of people getting infected, including hospital staff. As a result, some governments have responded with renewed restrictions in the hope of limiting any further pressure.

 

There will be an economic cost to this wave and the controls put in place. The cost will be largely borne by the services side of the economy, just as we have seen in prior episodes. In addition, there may be more disruption, staff shortages and loss of productivity across various industries in the near-term given the large number of people getting infected and being unable to work. Nevertheless, each successive wave of the virus has resulted in a smaller hit to the economy because governments, households and businesses have learned to function as best as possible. Investors expect these renewed disturbances and the associated impact to the economy to be relatively short-lived. Furthermore, some investors are holding out hope that the Omicron variant could be the catalyst that helps transition the virus from a pandemic to an endemic state, something that epidemiologists have expected to happen at some point in the future. This occurrence would mark a meaningful change, through which the virus would exist without leading to mass hospitalizations.

 

Amid all of the attention being paid to the coronavirus, there has been another development of late that may be more important for the broader markets. Government bond yields have been rising to start the year, suggesting that investors have been selling government bonds, pushing their prices lower and yields higher. Bond yields tend to be driven by expectations of the future. More specifically, investors may be anticipating stronger growth, higher inflation and/or higher interest rates. The U.S. Federal Reserve released notes from its December meeting which revealed that the Committee may be preparing to withdraw its supportive policy faster than the prior consensus view. Rising bond yields toward a neutral position is not a negative occurrence a bad thing, but these episodes can create short-term volatility as investors reposition their portfolios.

 

Most noticeably, we have witnessed some recent strength in sectors like Canadian banks, which tend to benefit from higher bond yields as they are a driver of lending margins. Sectors like technology and growth stocks in general have seen some weakness, given the sensitivities of their valuations to bond yields. The rotation may prove to be short-term in nature, similar to what we saw in the year-ago period when bond yields witnessed a similar, but limited, ascent. The rotation bears monitoring, however, because there is always the possibility of a more meaningful and sustained change in trend.

Should you have any questions, please feel free to contact us.

 

Drew M. Pallett LL.B. CFP Senior Portfolio Manager and Investment Advisor www.pallett.ca